If you have researched investment properties you have probably heard the term cap rate and net operating income (NOI). The cap rate on an investment property is a measure of what the returns will be assuming you pay cash for a property. I don’t use cap rate on my investment properties because it doesn’t factor financing costs. I prefer to use the cash on cash return on my properties, but the cap rate can still give you a basic idea of a property’s returns.
NOI is the net operating income on a rental property and does not factor in debt service either. The NOI can be another indicator of rental property returns, but can also be easily manipulated.
How do you figure the cap rate on a property?
The cap rate is a very simple formula:
Cap Rate = Net operating income divided by the price of a property.
For example if you buy a home for $100,000 and the net income is $10,000 a year, the cap rate is 10%. ($10,000/$100,000=10%) The cap rate can be figured very easily, but the tricky part is knowing how accurate the income numbers are on a particular property. The net operating income is used to figure the cap rate and that number can be easily manipulated.
What is the net operating income? (NOI)
The net operation income or NOI is the money the rental property will make after accounting for expenses. Debt service is not included, but property management, taxes and other expenses should be included. The NOI can easily be manipulated because different investors will use different expense numbers. Some investors will include allowances for vacancies and maintenance, while others will not. If a property is self-managed then the landlord many not include any expenses for property management. Make sure you do not blindly trust NOI figures given to you.
What expenses are included in the NOI?
You will find different investors include different expenses to determine the NOI. Some investors may include vacancies and property management and others may not. Some investors may not include any maintenance in their NOI projections to make their properties appear more profitable. If you are basing a purchase decision on the cap rate, then you need to make sure all the expenses are accounted for. If the total rent for a property is $10,000 a year and the NOI is $10,000, then there are obviously expenses being left out of the equation. Here are other expenses that should be included:
- Property taxes
- Property insurance
- Property management fees
- Utilities paid by landlord
- Ongoing maintenance paid by landlord
- Expected maintenance expenses
- HOA fees
- Any onsite management
How can the cap rate vary greatly on the same property?
The NOI greatly affects the cap rate. If the NOI does not include all expenses on a property, then the cap rate is going to be artificially inflated. I don’t like using the cap rate as an indicator of returns, because it does not factor in debt service and the cap rate can be easily manipulated. Here is an article about commercial real estate that shows how much the cap rate can change.
If you had $10,000 a year in gross income on a property that does not mean much because you have not accounted for expenses yet. If you only accounted for property taxes and insurance (which I have seen), the NOI might be $8,000 and the cap rate 8 percent. But when you add in the property management, expected maintenance and vacancies, the income may only be $5,000 which would only be a 5 percent cap rate.
Why cash flow or cash on cash returns are more important than the NOI
I think the cash flow or cash on cash returns are more important on a rental property then the cap rate. The cash flow tells you exactly how much money you are going to make including expenses and debt service. Our cash flow calculator even helps you determine what the maintenance and vacancies may be on a property per month. The cash on cash return will tell you what percentage you are making on the money you have invested, which is much more important to me than cap rate.
What can the cap rate tell you about different markets?
The cap rate gives a very basic idea of the return rate on rental properties. If you are looking to invest in long-distance properties, the cap rate can give you an idea of the returns in that area. Average cap rates in the country can range from 5% to 15%. There are many other factors to consider when determine where to buy, but cap rate can give you an idea on the returns in different areas. You have to make sure the cap rates you are looking at are accurate.
How can cap rates help you decide on single family versus multifamily?
The cap rates can also give you an idea of the different returns on single family homes versus multifamily homes in an area. In Colorado the cap rate for a multifamily property tends to be around 5%. For a single family home you can see cap rates at around 8% in my area. I buy my properties below market value and see cap rates at 10% or higher on the purchase of my single family rentals. In other markets those percentages may be reversed on single family and multifamily homes.
The cap rate and NOI can be used to help determine the returns on rental properties, but there are also many other factors to consider like the cash flow and cash on cash returns. I personally do not pay attention to cap rate or NOI because it does not give me a clear picture of my returns. I think it can give you a broad idea of what different markets have to offer investment wise. You have to make sure you are looking at a broad sample of properties and cap rates or really dig into the numbers yourself to make sure they are accurate.
For more information on how to buy the best rentals which will make the most money, check out my book: Build a Rental Property Empire: The no-nonsense book on finding deals, financing the right way, and managing wisely. The book is 374 pages long, comes in paperback or as an eBook and is an Amazon best seller.